My Cash Is Better Than Your Cash

This article considers the liquidity of firms, containing short-term advice for investors concerned about the threat of U.S. government default, now or in the future, and the continued government shutdown. By default, I specifically refer to nonpayment of the interest and principal of U.S. credit obligations or the partial nonpayment of such obligations. As of this writing a short-term deal, pushing the debt ceiling deadline back until late November has been rejected.

Let's talk about cash. The first line item on a U.S. GAAP balance sheet is "Cash and Cash Equivalents," presumed to be the most liquid and least risky asset. According to the FASB Accounting Standards Codification (sign up for free basic access) Topic 305, "Cash equivalent" can include short-term, highly liquid investments have the following characteristics

That are readily convertible to known amounts of cash

So near their maturity that they present insignificant risk of changes in value because of changes in interest rate.

It is generally accepted that investments with an original maturity of 90 days or less, such as Treasury bills or money market funds, can be classified by firms as a cash equivalent. It is also accepted that a Treasury bond with a longer original maturity purchased with 90 days or less to maturity can be classified as a cash equivalent. Firms are required to spell out what they hold out to be Cash and Cash Equivalents but not to disclose the breakdown of this account. This renders a thorough analysis of the true risk a firm bears with regards to its Cash and Cash Equivalents account nearly impossible in the event of a U.S. default, unless of course a firm chooses to exclude U.S. obligations from its Cash and Cash Equivalents. Ratios such as the quick, current and defensive interval become less meaningful when cash equivalents are not liquid.

There is growing evidence that some firms are recognizing this possibility. The chart below is created from U.S. Treasury data. The short end is now kinked. Short-term rates have dramatically increased while longer rates have fallen. In other words, the value of firm's Cash Equivalents has fallen.

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Fidelity and JP Morgan recently announced that they have exited all U.S. government positions coming due in late October and early November.

The Thursday Wall Street Journal reported that the repo rate has moved to 0.25% from 0.14% in three days. Lenders are demanding higher interest for their loans backed by Treasuries.

In the event of a federal default, "cash equivalents" will not be liquid or must be sold at a deep discount but a firm can sell other liquid assets, such as accounts receivable. If we presume all firms are at equal risk with regards to their cash equivalent holdings, firms with questionable accounts receivable are most vulnerable. Given the shutdown and the threat of default, certain federal contractors are most at risk for liquidity problems. Those would be the ones with contracts that have stopped payment or cannot be worked because the federal agency is furloughed. We all know that the department of defense has been summoned back to work and presumably most of the DOD contracts are being paid. Therefore, firms with a higher percentage of non-DOD contracts are most at risk. Two firms, identified through their disclosures, with over 20% of their revenue derived from non-DOD contracts are Lockheed Martin (NYSE:LMT) and newly formed SAIC (NYSE:SAIC). Lockheed Martin and SAI, formerly encompassing SAIC, both define "cash and cash equivalents" to include highly liquid investments. I have put in requests to both these firms' investor relations departments this week with specific questions but have not heard back.

*The data is taken from pro-forma statements which include borrowings of $500 million. Otherwise the cash ratio would be less than 0.01

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Since this article focuses on liquidity, I do not intend to delve deeply into the world of the Federal Acquisition Regulations, FAR, and federal contracting. However, certain factors should be noted. First, SAIC states that its cash flow may be hurt because the U.S. government canceled its accelerated payment initiative. Secondly, the federal government pays the prime contractor, "prime", who in turn pays the subcontractors, "subs". Therefore, primes are better able to manage their cash flow. SAIC stated that 91% of contracts, by revenue, are derived from prime contracting. Lockheed Martin did not specify a percent but stated that it is a prime on most of their contracts. A prime increasing payment time to its subs may be experiencing cash flow issues.

It is possible that SAIC and Lockheed will have ample cash flow to survive temporary political fighting and, thus, neither reach into revolving credit lines, nor furlough additional workers (in the case of Lockheed). Perhaps, Washington is paying more bills than it is letting on. However, given the continued shutdown and ambiguity of what contracts are essential (or whatever term Washington is currently using for paying contracts) and non-essential (or whatever term Washington is using for Non-paying contracts), the cash and accounts receivable line items should be monitored closely by investors until the shutdown is over.

Conclusions:

Investors who hold long positions and believe that a default or the threat of default is possible, but the government will become functional in the short term may want to consider purchasing put positions expiring in early 2014 either on individual positions held or (NYSEARCA:SPY), especially on days that the market rallies, as protection becomes cheaper.

Investors who hold positions in SAIC, Expected Dividend payable on 10/30/13, no announced earnings call, or Lockheed Martin, Expected Dividend payable 12/27/13, 10/22/13 earnings, call should consider put options and listen closely to the earnings call for clues as to how the shutdown and threat of default has affected cash flow and earnings. Specifically what their corporate treasury departments are doing to manage cash flow (revolving credit lines, furloughs, etc), the percentage of prime contracts the firm holds, the percentage of contracts that cash is actually flowing to the firm, how the firms are handling payments to subcontractors, and the effects on guidance for FY2014.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may initiate put protection on SPY.I have no positions on LMT, SAIC, or GD.